How to grade your trades

The goal of trading is to make money, but can you use money to measure the quality of every single trade? I believe that the amount of profit or loss provides only a very crude measurement of a trade’s quality.

The amount of money in your account at the end of a month or a quarter is extremely important for plotting the equity curve. That curve provides an accurate measure of your performance as trader. Money does not provide a good measure of any individual trade because theamount you make or lose in a single trade heavily depends on the trade’s size as well as the market’s current volatility.

The best way to rate your performance in any single trade is to measure the number of points gained or lost against the market’s recent volatility. What has been the normal swing of that market in recent months? What percentage of that swing did you catch in the latest trade? Answering these questions will provide a good measure of your performance in that trade.

What yardstick should we use to rate a trade’s quality? A well-drawn channel on the daily chart serves as an excellent reflection of that market’s recent volatility. Our trade grade will show what percentage of the channel we have managed to capture.

For swing trades, I use a channel around the longer moving average on the daily chart. For day-trades, I use a channel on a 5-minute chart, also centered around the longer moving average.

One of the few scientifically proven facts about the financial markets is that they fluctuate above and below value. As a psychiatrist, Ican say that the market is manic-depressive. When it becomes manic,prices rise above the upper channel line. When it becomes depressed,prices fall below the lower channel line. While prices keep swinging between mania and depression, I rate the quality of each trade by the percentage of the channel it captured.


A moving average reflects the average consensus of value, but what is the meaning of a channel?

The upper channel line reflects the power of bulls to push prices above the moving average—the average consensus of value. It marks the normal limit of market optimism. The lower channel line reflects the power of bears to push prices below the average consensus of value. It marks the normal limit of market pessimism. A well-drawn channel helps diagnose mania and depression.

Most software programs draw channels according to this formula:

Upper Channel Line = EMA + EMA . Channel Coefficient

Lower Channel Line = EMA . EMA . Channel Coefficient

A well-drawn channel contains the bulk of prices, with only a few extremes poking out. Adjust the coefficient until the channel contains approximately 95 percent of all prices for the past several months. Mathematicians call this the second standard deviation channel. Most software packages make drawing them very easy.

Find proper Channel Coefficients for any market by trial and error. Keep adjusting them until the channel holds approximately 95% of all data, with only the highest tops and the lowest bottoms sticking out. Drawing a channel is like trying on a shirt. Choose the size in which the entire body fits comfortably, with only the wrists and the neck poking out.

Adapted from Come into My Trading Room, by Dr. Alexander Elder,
John Wiley & Sons, Inc., 2002

I measure the channel height—the upper line minus the lower line—on the day of the entry into a trade. If you look at Figure 3.1, you will see that column W tracks the percentage of a channel captured in every trade. This is the most important ranking for every trade. Even if you score 100% on your entry and exit but get a low single-digit or even negative number for your trade grade, the trade is a failure. Not a total failure, of course—as long as you keep good records, you are learning from losing as well as from winning trades.

And what about column X in Figure 3.1? Here I fall back on the old school system and call every trade that captures 30% or more of the channel an A trade. Sometimes there are even A+ trades. Any trade that captures 20% to 30% of a channel gets rated B; 10% to 20%, C; below 10%, a C.; and below zero it becomes a D trade. If you now return to Figure 3.3, showing my Outlook Calendar, you will understand why the labels for some winning trades are colored green (Profit) and others blue (Profit Demerit). It is not enough to make profits—it is just as important to earn a good performance grade.

Grading every entry and exit as well as every trade will lead you to adopt a demanding and tough-minded attitude towards your work. As a private trader, you have no manager. To win, you must become your own manager, and that’s what trade ratings help you accomplish.

If you like the rating system I’ve shown you, you can expand it even further. For example, you may want to add a column to your spreadsheet measuring the cost of your trades—the total cost of commissions, fees, and slippage divided by the gross profit from that trade.

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